The Gold Market

Part 1

by J. Orlin Grabbe

The gold market is a unique 24-hour-a-day market for the purchase or sale
of one of history's longest-valued commodities. What gives the market its special
character is the use of gold simultaneously as industrial commodity, as decoration
(jewelry), and as a monetary asset. To understand the gold market, it is important
to understand the latter function. Because gold has often formed a component of
the local money supply, its history is intertwined with national and central bank
politics.

Gold as Money

Gold is only one of many commodities that over the years have served as
money--as a medium of exchange--in international trade and financial
transactions. Such commodities have frequently varied. In many local
communities (including nation-states), the most widely used commodity, or the
product most traded with outsiders, has often functioned as money. In the Oregon
territory from 1830 to 1840, for example, beaver skins were a customary medium
of exchange. Then, as the population shifted from fur trapping to farming, wheat
became the chief form of money, and from 1840 to 1848 promissory notes were
made payable in so many bushels of wheat. Later, with the California gold
discoveries in 1848, the Oregon legislature repealed the law making wheat legal
tender, and proclaimed that thereafter only gold and silver were to be used to
settle taxes and debts. For similar reasons, tobacco long served as the principal
currency in Virginia. When the Virginia Company imported 150 "young and
uncorrupt girls" as wives for the settlers in 1620 and 1621, the price per wife was
initially 100 pounds of tobacco--later climbing to 150 pounds.

Only a few currencies, however, have had long-run durability as well as
multi-territorial acceptability. Silver and gold are two of these. Roughly
speaking, from the time of Columbus' discovery of America in 1492 to the
California gold discovery in 1848, silver dominated in common circulation in
America and Europe, while gold came into dominance following the Californian
and Australian gold discoveries (see Chapter 8 in J. Laurence, The History of
Bimetallism in the United States, D. Appleton and Company, 1901). Under the
rule of the British Empire, the British pound sterling and the gold standard were
adopted in much of the world. Toward the end of World War Two, the U.S.
dollar and gold became the principal international reserve assets under the Bretton
Woods agreement--a market position the U.S. dollar and gold have maintained
despite the de facto dissolution of that system in the early 1970s.

The Post-WW2 Politics of Gold

Under the Bretton Woods Agreement forged at the Mt. Washington Hotel
in Bretton Woods, New Hampshire in 1944, each member of the newly created
International Monetary Fund (IMF) agreed to establish a par value for its
currency, and to maintain the exchange rate for its currency within 1 percent of
par value. In practice, since the principal reserve currency would be the U.S.
dollar, this meant that other countries would peg their currencies to the U.S.
dollar, and--once convertibility was restored--would buy and sell U.S. dollars to
keep market exchange rates within the 1 percent band around par value. The
United States, meanwhile, separately agreed to buy gold from or sell gold to
foreign official monetary authorities at $35 per ounce in settlement of
international financial transactions. The U.S. dollar was thus pegged to gold,
and any other currency pegged to the dollar was indirectly pegged to gold at a
price determined by its par value.

What does it mean to fix the price (the exchange value) of a currency or a
commodity like gold? If no trading other than with official authorities is allowed
(as when something is "inconvertible"), then fixing the price is easy. The central
bank or exchange authority simply says the price is "X" and no one can say
differently. If you want to trade gold for dollars, you have to deal with the central
bank, and you have to trade at central bank prices. The central bank may in fact
even refuse to trade with you, but it can still maintain the lawyerly notion that the
exchange rate is "fixed." (Such a refusal, of course, will only lead to black market
trading outside official channels.) If, however, free trade is allowed, fixing the
price requires a great deal more. The price can be fixed only by altering either the
supply of or the demand for the asset. For example, if you wanted to fix the price
of gold at $35 per ounce, you could only do so by being willing and able to supply
unlimited amounts of gold to the market to drive the price back down to $35 per
ounce whenever there would otherwise be excess demand at that price, or to
purchase unlimited amounts of gold from the market to drive the price back up to
$35 per ounce whenever there would otherwise be excess supply at that price.

In order to peg the price of gold you would thus need two things: a large
stock of gold to supply to the market whenever there is a tendency for the market
price of gold to go up, and a large stock of dollars with which to purchase gold
whenever there is a tendency for the market price of gold to go down. No
problem. The U.S. had plenty of gold--about 60 percent of the world's stock.
And, naturally, it also had plenty of dollars, which could be created with the
stroke of a pen.

After the Bretton Woods Agreement, the price of gold remained
uncontroversial for the next decade. But around 1960 the private market price of
gold began to show a persistant tendency to rise above its official price of
$35/ounce. So, in the fall of 1960, the United States joined with the central banks
of the Common Market countries as well as with Great Britain and Switzerland to
intervene in the private market for gold. If the private market price did not rise
above $35 per ounce, it was felt, the Bretton Woods price was de facto the correct
price, and in addition no one could complain if dollars were not exchangeable for
gold. This coordinated intervention, which involved maintaining the gold price
within a narrow range around $35 per ounce, became formalized a year later as the
gold pool. Since London was the center of world gold trading, the pool was
managed by the Bank of England, which intervened in the private market via the
daily gold price fixing at N. M. Rothschild.

The London Gold Fixing

In its current form, the London gold price fixing takes place twice each
business day, at 10:30 A.M. and 3:00 P.M. in the "fixing room" of the merchant
banking firm of N. M. Rothschild. Five individuals, one each from five major
gold-trading firms, are involved in the fixing. The firms represented are Mocatta
& Goldsmid, a trading arm of Standard Chartered Bank; Sharps Pixley, a dealer
owned by Deutsche Bank; N. M. Rothschild & Sons, whose representative acts as
the auctioneer; Republic-Mase, a bullion subsidiary of Republic Bank; and
Samuel Montagu, a merchant banking subsidiary of Midland Bank (owned by
HSBC). Each representative at the fixing keeps an open phone line to his firm's
trading room. Each trading room in turn has buy and sell orders, at various prices,
from customers located all over the world. In addition, there are customers with
no existing buy or sell orders who keep an open line to a trading room in touch
with the fixing and who may decide to buy or sell depending on what price is
announced. The N. M. Rothschild representative announces a price at which
trading will begin. Each of the five individuals then confers with his trading room,
and the trading room tallies up supply and demand--in terms of 400-ounce bars--
from orders originating around the world. In a few minutes, each firm has
determined if it is a net buyer or seller of gold. If there is excess supply or demand
a new price is announced, but no orders are filled until an equilibrium price is
determined. The equilibrium price, at which supply equals demand, is referred to
as the "fixing price." The A.M. and P.M. fixing prices are published daily in major
newspapers.

Even though immediately before and after a fixing gold trading will
continue at prices that may vary from the fixing price, the fixing price is an
important benchmark in the gold market because much of the daily trading
volume goes through at the fixing price. Hence some central banks value their
gold at an average of daily fixing prices, and industrial customers often have
contracts with their suppliers written in terms of the fixing price. Since a fixing
price represents temporary equilibrium for a large volume of trading, it may be
subject to less "noise" than are trading prices at other times of the day. Usually the
equilibrium fixing price is found rapidly, but sometimes it takes twenty to thirty
tries. Once in October 1979, with supply and demand fluctuating rapidly from
moment to moment, the afternoon fixing in London lasted an hour and thirty-nine
minutes.

The practice of fixing the gold price began in 1919. It continued until
1939, when the London gold market was closed as a result of war. The market
was reopened in 1954. When the central bank gold pool began officially in 1961,
the Bank of England--as agent for the pool--maintained an open phone line with
N. M. Rothschild during the morning fixing (there was as yet no afternoon fixing).
If it appeared that a fixing price would be established that was above $35.20 or
below $34.80, the Bank of England (as agent) became a seller or buyer of gold in
an amount sufficient to ensure that the fixing price remained within the prescribed
bands.

Gold and European Union

While the gold pool held down the private market price of gold, gold
politics took a new turn in the international arena. This was related to the fact that
European countries, which had complained of a "dollar shortage" in the 1950s,
where now complaining of a "dollar glut." They were accumulating too many
dollar reserves. Although it was actually Germany that was running the greatest
surplus and accumulating the most dollar reserves in the early 1960s, it was
France under the leadership of Charles de Gaulle that made the most noise about
it. During World War II, in conversations with Jean Monnet, de Gaulle had
supported the notion of a united Europe--but a Europe, he insisted, under the
leadership of France. After the war, France had opposed the American plan for
German rearmament even in the context of European defense. France had been
induced to agree, however, through Marshall Plan aid, which France was not
inclined to refuse after it became embroiled in the Indo-China War. But now, in
the 1960s, de Gaulle's vision of France as a leading world power led him to
withdraw from NATO because NATO was a U.S.-dominated military alliance. It
also led him to oppose Bretton Woods, because the international monetary system
was organized with the U.S. dollar as a reserve currency.

In the early 1960s there was, however, no realistic alternative to the dollar
as a reserve asset, if one wanted to keep reserves in a form that both would bear
interest and could be traded internationally. Official dollar-reserve holders not
only were made exempt from the interest ceilings of the Federal Reserve's
Regulation Q for their deposits in New York but also began as a regular practice
to hold dollars in the eurodollar market--a free market where interest rates found
their own level. Prior to 1965, central banks were the largest suppliers of dollars
to the euromarket. Thus dollar reserve holders received a competitive return on
their dollar assets, and the United States gained no special benefit from the use of
the dollar as a reserve asset.

Nevertheless, de Gaulle's stance on gold made domestic political sense,
and in February 1965, in a well-publicized speech, he said: "We hold as necessary
that international exchange be established . . . on an indisputable monetary base
that does not carry the mark of any particular country. What base? In truth, one
does not see how in this respect it can have any criterion, any standard, other than
gold. Eh! Yes, gold, which does not change in nature, which is made indifferently
into bars, ingots and coins, which does not have any nationality, which is held
eternally and universally. . . ." By the "mark of any particular country" he had in
mind the United States, which announced the Foreign Credit Restraint Program
about a week later, in part as a direct response to de Gaulle's speech. France
stepped up its purchases of gold from the U.S. Treasury and in June 1967, when
the Arab-Israeli Six-Day War led to a large increase in the demand for gold,
withdrew from the gold pool.

The Two-Tier System

Then in November 1967, the British pound sterling was devalued from its
par value of $2.80 to $2.40. Those holding sterling reserves took a 14.3 percent
capital loss in dollar terms. This raised the question of the exchange rate of the
other reserve assets: if the dollar was to be devalued with respect to gold, a capital
gain in dollar terms could be made by holding gold. Therefore demand for gold
rose and, as it did, gold pool sales in the private market to hold down the price
were so large that month that the U.S. Air Force made an emergency airlift of gold
from Fort Knox to London, and the floor of the weighing room at the Bank of
England collapsed from the accumulated tonnage of gold bars.

In March 1968, the effort to control the private market price of gold was
abandoned. A two-tier system began: official transactions in gold were insulated
from the free market price. Central banks would trade gold among themselves at
$35 per ounce but would not trade with the private market. The private market
could trade at the equilibrium market price and there would be no official
intervention. The price immediately jumped to $43 per ounce, but by the end of
1969 it was back at $35. The two-tier system would be abandoned in November
1973, after the emergence of floating exchange rates and the de facto dissolution
of the Bretton Woods agreement. By then the price had reached $100 per ounce.

When the gold pool was disbanded and the two-tier system began in
March 1968, there was a two-week period during which the London gold market
was forceably closed by British authorities. A number of important changes took
place during those two weeks. South Africa as a country was the single largest
supplier of gold and had for years marketed the sale of its gold through London,
with the Bank of England acting as agent for the South African Reserve Bank.
With the breakdown of the gold pool, South Africa was no longer assured of
steady central bank demand, and--with the London market temporarily closed--the
three major Swiss banks (Swiss Bank Corporation, Swiss Credit Bank, and Union
Bank of Switzerland) formed their own gold pool and persuaded South Africa to
market through Zurich.

In 1972, the second major country supplier of gold, the Soviet Union, also
began to market through Zurich. In 1921, V. I. Lenin had written, "sell [gold] at
the highest price, buy goods with it at the lowest price." Since the Soviet ruble
was not convertible, the Soviet Union used gold sales as one major source of its
earnings of Western currencies, and in the 1950s and 1960s sold gold through the
Moscow Narodny in London (a bank that had also provided dollar cover for the
Soviets during the early days of the Cold War). In Zurich, the Soviet Union dealt
gold via the Wozchod Handelsbank, a subsidiary of the Soviet Foreign Trade
Bank, the Vneshtorgbank. (In March 1985, the Soviet Union announced that the
Wozchod would be closed because of gold-trading losses and would be replaced
with a branch office of the Vneshtorgbank. The branch office, unlike the
Wozchod, would not be required to publish information concerning operations.)

London, in order to stay competitive, subsequently turned itself more into
a gold-trading center than a distribution center. When the London market
reopened in March 1968 after the two-week "holiday," a second daily fixing (the
3:00 P.M. fixing) was added in order to overlap with U.S. trading hours, and the
fixing price was switched to U.S. dollar terms from pound sterling terms. But by
the 1980s, London's new role as a trading center had begun to be challenged by
the Comex gold futures market in New York.

The SDR as "Paper Gold"

During the early years of the gold pool, it came to be believed that there
was a deficiency of international reserves and that more reserves had to be created
by legal fiat to enable reserve-holders to diversify out of the U.S. dollar and gold.
In retrospect, this was a curious view of the world. The form in which reserves are
held will ultimately always be determined on the basis of international
competition. People will hold their wealth in the form of a particular asset only if
they want to. If they do not have an economic incentive to desire a particular asset,
no legal document will alter that fact. A particular currency will be attractive as a
reserve asset if these four criteria exist: (1) an absence of exchange controls so
people can spend, transfer, or exchange their reserves denominated in that
currency when and where they want them; (2) an absence of applicable credit
controls and taxes that would prevent assets denominated in the currency from
bearing a competitive rate of return relative to other available assets; (3) political
stability, in the sense that there is a lack of substantial risk that points (1) and (2)
will change within or between government regimes; (4) a currency that is in
sufficient use internationally to limit the costs of making transactions. These four
points explain why, for example, the Swiss but not the French franc has been
traditionally used as an international reserve asset.

Many felt that formal agreement on a new international reserve asset was
nevertheless needed, if only to reduce political tension. And while France wanted
to replace the dollar as a reserve asset, other nations were looking instead for a
replacement for gold. The decision was made by the Group of Ten (ten OECD
nations with most of the voting rights in the IMF) to create an artificial reserve
asset that would be traded among central banks in settlement of reserves. The
asset would be kept on the books of the IMF and would be called a Special
Drawing Right (SDR). In fact it was a new reserve asset, a type of artificial or
"paper gold," but it was called a drawing right by concession to the French, who
did not want it called a reserve asset.

The SDR was approved in July 1969, and the first "allocation" (creation)
of SDRs was made in January l970. Overnight, countries gained more reserves at
the IMF, because the IMF added new numbers to its accounts and called these
numbers SDRs. The timing of the allocation was especially maladroit. In the
previous four years the United States had been in the process of financing the
Great Society domestic social programs of the Johnson administration as well as a
war in Vietnam, and the world was being flooded with more reserves than it
wanted at the going price of dollars for deutschemarks, yen, or gold. In the 1965
Economic Report of the President, Johnson wrote, in reference to his Great
Society Program and the Vietnam War: "The Federal Reserve must be free to
accommodate the expansion in 1965 and the years beyond 1965." U.S. money
supply (M1) growth, which had averaged 2.2 percent per year during the 1950s,
inched upward slightly during the Kennedy years (2.9 percent per year for 1961-
1963) but changed materially under the Johnson administration. The growth rate
of M1 averaged 4.6 percent per year over 1964-1967, then rose to 7.7 percent in
1968. Under the Nixon administration that followed, money growth initially
slowed to 3.2 percent in 1969 and 5.2 percent in 1970, then accelerated to 7.1
percent for 1971-1973. The latter three years would encompass the breakdown of
Bretton Woods, and would also have a material effect on the price of gold.

How Foreign Exchange Intervention Affects the Money Supply

In order to succeed, a regime of fixed exchange rates (and under Bretton
Woods, rates for the major currencies were fixed in terms of their par values,
which could not be casually altered) requires coordinated economic policies,
particularly monetary policies. If two different currencies trade at a fixed
exchange rate and one currency is undervalued with respect to the other, the
undervalued currency will be in excess demand. By the end of the 1960s both the
deutschemark and the yen had become undervalued with respect to the U.S.
dollar. Therefore the countries concerned (Germany and Japan) had two choices:
either increase the supplies of their currencies to meet the excess demand or adjust
the par values of their currencies upward enough to eliminate the excess demand.

As long as either country intervened in the market to maintain the par
value of its currency with respect to the U.S. dollar, an increased supply of the
domestic currency would take place automatically. To see why this is so, take the
case of Germany. In order to keep the DM from increasing in value with respect to
the U.S. dollar, the Bundesbank would have to intervene in the foreign exchange
market to buy dollars. It would buy dollars by selling DM. The operation would
increase the supply of DM in the market, driving down DM's relative value, and
increase the demand for the dollar, driving up the dollar's relative value.

Any time the central bank intervenes in any market to buy or sell
something, it potentially changes the domestic money supply. If the central bank
buys foreign exchange, it does so by writing a check on itself--by giving credit to
the seller. Central bank assets go up: the central bank now owns the foreign
exchange. But central bank liabilities go up also, since the check represents a
central bank liability. The seller of the foreign exchange or other asset will deposit
the central bank's check, in payment for the value of the assets, in an account at a
commercial bank. The commercial bank will in turn deposit the check in its
account at the central bank. The commercial bank will now have more reserves, in
the form of a deposit at the central bank. The bank can use the reserves to make
more loans, and the money supply will expand by a multiple of the initial reserve
increase.

Is there anything the German authorities can do to prevent the money-
supply increase? Essentially not, as long as they attempt to maintain the fixed
exchange rate. There is, however, an operation referred to as sterilization.
Sterilization refers to the practice of offsetting any impact on the monetary base
caused by foreign exchange intervention, by making reverse transactions in terms
of domestic assets (such as government bonds). For example, if the money base
went up by DM4 billion because the central bank bought dollars in the foreign
exchange market, a sterilization operation would involve selling DM4 billion
worth of domestic assets to reduce central bank liabilities by an equal and
offsetting amount. If the Bundesbank sold domestic assets, these would be paid
for by checks drawn on the commercial banking system and reserves would
disappear as the commercial banks' checking accounts were debited at the central
bank.

However, the Bundesbank could not simultaneously engage in complete
sterilization (a complete offset) and also maintain the fixed exchange rate. If there
was no change in the supply of DM, the DM would continue to be undervalued
with respect to the dollar, and foreign exchange traders would continue to
exchange dollars for DM. During the course of 1971, the Bundesbank intervened
so much that the German high-powered money base would have increased by 42
percent from foreign exchange intervention alone. About half this increase was
offset by sterilization, but, even so, the increase in the money base--and eventually
the money supply--by more than 20 percent in one year was enormous by German
standards. The breakdown of the Bretton Woods system began that year.

The Breakdown of Bretton Woods

It came about this way. From the end of World War II to about 1965, U.S.
domestic monetary and fiscal policies were conducted in such a way as to be
noninflationary. As world trade expanded during this period, the relative
importance of Germany and Japan grew, so that by the end of the 1960s it was
unreasonable to expect any system of international finance to endure without a
consensus at least among the United States, Germany, and Japan. But after 1965,
U.S. economic policy began to conflict with policies desired by Germany and
Japan. In particular, the United States began a strong expansion, and moderate
inflation, as a result of the Vietnam War and the Great Society program.

When it became obvious that the DM and yen were undervalued with
respect to the dollar, the United States urged these two nations to revalue their
currencies upward. Germany and Japan argued that the United States should
revise its economic policy to be consistent with those in Germany and Japan as
well as with previous U.S. policy. They wanted the United States to curb money-
supply growth, tighten credit, and cut government spending. In the ensuing
stalemate, the U.S. policy essentially followed the recommendations of a task
force chaired by Gottfried Haberler. This was a policy of officially doing nothing
and was commonly referred to as a policy of "benign neglect." If Germany and
Japan chose to intervene to maintain their chosen par values, so be it. They would
be allowed to accumulate dollar reserves until such time as they decided to change
the par values of their currencies. That was the only alternative if the United
States would not willingly change its policy. It was clearly understood at the time
that a unilateral action on the part of the United States to devalue the dollar by
increasing the dollar price of gold would be matched by similar European
devaluations.

In April 1971, the Bundesbank took in $3 billion through foreign exchange
intervention. On May 4 it took in $1 billion in the course of the day. On May 5 the
Bundesbank took in $1 billion during the first hour of trading, then suspended
intervention in the foreign exchange market. The DM was allowed to float
upward. On August 15 the U.S. president, Nixon, suspended the convertibility of
the dollar into gold and announced a 10 percent tax on imports. The tax was
temporary and was intended to signal the magnitude by which the United States
thought the par values of the major European and Japanese currencies should be
changed.

An attempt was made to keep the Bretton Woods system going by a
revised agreement, the Smithsonian agreement, reached at the Smithsonian
Institution in Washington on December 17-18, 1971. Called by President Nixon
"the most important monetary agreement in the history of the world," it lasted
only slightly more than a year, but beyond the 1972 U.S. presidential election. At
the Smithsonian Institution the Group of Ten agreed on a realignment of
currencies, an increase in the official price of gold to $38 per ounce, and expanded
exchange rate bands of 2.25 percent around their new par values.

Over the period February 5-9, 1973, history repeated itself, with the
Bundesbank taking in $5 billion in foreign exchange intervention. On February
12, exchange markets were closed in Europe and Japan, and the United States
announced a 10 percent devaluation of the dollar. European countries and Japan
allowed their currencies to float and, over the next month, a de facto regime of
floating exchange rates began. The floating rate system has persisted to the
present, with none of the five most widely traded currencies (the dollar, the DM,
the British pound, the Japanese yen, the Swiss franc) in any way officially fixed in
exchange value with respect to the others. (Briefly, from October 1990 to
September 1992, the DM and the British pound were nominally linked in the
Exchange Rate Mechanism of the European Monetary System.) With the
breakdown of Bretton Woods, there began a slow dismantling of the array of
controls that had been erected in its name. This included gold.

As part of the Jamaica agreement in 1976 (which ludicrously proclaimed a
"New International Economic Order"), IMF members agreed to demote the role of
gold. But few central banks subsequently followed up this agreement in practice.
One associated change that did come about, however, affected the private gold
market in the United States. On January 2, 1975, after forty years of prohibition,
U.S. citizens were allowed to purchase gold bullion legally. The Comex in New
York subsequently became an important center for the trading of gold futures.